In the town of Ceelo, Bob owns a successful lawn business and sometimes needs to borrow money so he can invest into a new mower. When Bob needs a loan, he borrows money from the First National Bank of Ceelo. The money he borrows is part of the money supply of the economy. Margie runs a cake bakery with some of the best and creamiest chocolate cakes that you've ever tasted. She's a business owner like Bob, but she gets a paycheck just like the other workers in her bakery and when she does, she takes it to the First National Bank of Ceelo to deposit it. Her paycheck is part of the money supply.

The money supply is a stock of safe assets that households and businesses can use to make payments or to hold as short-term investments. Common examples of the money supply include the currency and coins in circulation but also checking and savings accounts, like the one Margie deposits her paycheck into.

Banks like the First National Bank of Ceelo are members of a much larger system of banks with one central bank at the top, like the top of a pyramid, much like the one you'll find on the back of a one dollar bill. The central bank in the United States is called the Federal Reserve. Its main objectives include full employment, stable prices and moderate interest rates, all of which tend to lead to long-run economic growth. How do they achieve these objectives? Using the three basic tools that we're talking about in this lesson: open market operations, reserve requirements and the discount rate. These three tools enable the central bank to change the money supply and therefore stimulate the economy or slow it down. The first tool is called open market operations.

Open Market Operations

The Fed has a very unique arrangement with the Federal government. It finances the government by buying U.S. government bonds. This enables the congress to spend more money than it takes in with tax revenues, and more importantly, it provides the central bank with a great deal of influence over the economy.

Open market operations are the purchases and sales of government securities in the open market by the Federal Reserve.

When it buys government bonds, it uses new money to pay for them, an arrangement that gives the Federal Reserve control over the size of the money supply. While some of this new money could be actual currency, usually it's in the form of numbers added to a bank account electronically. Where does this new money come from? It's created out of thin air. Sometimes I wish I had this power!

Once the Fed buys these government securities in the open market, the money supply immediately goes up, and this initial increase leads to a multiplied increase in money throughout the economy, as banks lend out their excess reserves through what economists call 'the multiplier effect.'

But the Fed can also sell government securities, and the money supply will go down. This is a very powerful thing because changes in the money supply lead to changes in interest rates, and interest rates influence a lot of decisions throughout the economy. Basically, the Federal Reserve has a lot of influence over aggregate demand because interest rates affect the level of saving and investment within the economy.

When banks borrow money from other banks, they use what's called the federal funds rate. The federal funds rate is the interest rate charged by banks for overnight loans. This is the interest rate that the Fed directly controls by changing the money supply. If they want to set the Fed funds rate at 3%, then they buy or sell enough government securities to cause the interest rate to settle at this target rate of 3%.

Banks borrow from other banks at the federal funds rate.

Banks, in turn, loan out money at the prime rate. The prime rate is the interest rate that banks charge to their best customers. Of course, for other customers, they would get a higher rate than that, but the prime rate is for the best customers. The Federal Reserve keeps a firm grip on the money supply through its open market operations and thereby controls interest rates. So this is the first of the three tools.

Reserve Requirements

The second tool of the Federal Reserve is called reserve requirements, which is the proportion of customers' deposits a bank is required by the Federal Reserve to hold in reserve without loaning out. The biggest benefit to the commercial bank of setting aside a reserve is that this bank will have enough cash on hand to cover the withdrawals of money that consumers might need on a regular basis. However, the main reason that the Federal Reserve requires commercial banks to maintain reserves with them is to give the Federal Reserve more control over the money supply, which is a very powerful tool that often results in immediate changes within the economy.

For example, when the Fed changes the reserve requirement from 10% to 20%, that means banks are suddenly required to reserve twice as much money out of every deposit than they did before. Whatever they have to reserve cannot be loaned out, so fewer loans take place. And this means a smaller money supply. It also means higher interest rates and lower economic output.

On the other hand, when the Fed lowers the reserve requirement, from, say, 20% to 10%, the opposite scenario takes place. Banks hold fewer reserves and therefore, loan out more money, which stimulates economic output. To see the effects of a change in reserve requirements, just think about this example.

When the Fed lowers the reserve requirements from 20% to 10%, let's say, the money multiplier, whose formula is 1 divided by the reserve ratio, increases from 5 to 10, as follows: 1 divided by 20% equals 5 versus 1 divided by 10% is equal to 10. If excess reserves in the banking system started at $100,000, then the money supply would be $100,000 times 5 which is equal to $500,000. However, when the money multiplier doubles from 5 to 10, the money supply doubles from $500,000 to $1,000,000. So this change in the reserve requirement from 20% to 10% just led to a doubling of the money supply.

The Discount Rate

When banks cannot borrow from other banks, they can borrow money from the Fed.

The third tool of the Federal Reserve is called the discount rate, which is the interest rate charged when member banks borrow directly from the Federal Reserve.

Once in a while, the reserves inside a bank's vault fall below the Fed's required reserve amount. Under normal circumstances, banks borrow from each other. As I said before, when a bank borrows from another bank, the rate of interest it pays on that loan is called the federal funds rate. However, during a crisis, banks may not be able to borrow from each other and choose to borrow from the Fed instead. This is why the Fed is referred to as 'the lender of last resort.' When a bank borrows directly from the Fed, it pays the discount rate, which is set directly by the Fed.

Lesson Summary

Alright, let's review. The money supply is a stock of safe assets that households and businesses can use to make payments or to hold as short-term investments.

The Federal Reserve, which is called the Fed for short, is the central bank of the United States, and it controls the money supply in America. It's referred to as 'the lender of last resort' because of its ability to step in and loan out money when banks get into trouble. The one thing that the Fed does not do is bank with individuals or businesses directly.

Open market operations are the purchases and sales of government securities in the open market by the Federal Reserve. When the Fed buys government securities in the open market, the money supply increases. Likewise, when the Fed sells government securities, the money supply decreases.

The second tool of the Federal Reserve is called reserve requirements, which is the proportion of customers' deposits a bank is required by the Fed to hold in reserve without loaning out. In a fractional reserve banking system, all member banks are required to do this. The main reason that the Federal Reserve requires commercial banks to maintain reserves is to give the Federal Reserve more control over the money supply.

The third tool of the Federal Reserve is called the discount rate, which is the interest rate charged when member banks borrow directly from the Federal Reserve. The federal funds rate is the interest rate charged by banks for overnight loans. The Federal Reserve attempts to keep this rate at a certain predetermined target by changing the money supply. Banks, in turn, loan out money at the prime rate. The prime rate is the interest rate that banks charge to their best customers.

When the Fed wishes to stimulate economic growth, it can increase the money supply by purchasing U.S. government securities in the open market, by lowering the reserve requirement or by lowering the discount rate. On the other hand, when the Fed wishes to cool the economy down, it can decrease the money supply by selling U.S. government bonds, increasing the reserve requirement or raising the discount rate.

So these are three major tools our central bank uses to control the money supply and thereby influence interest rates, and now you know more about what they do and how they do it.

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